JakilaTheHun (99.91)

Housing Might Rebound Stronger than Expected

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The original version of this article can be found on Seeking Alpha at this link. You can view the enlarged versions of the charts there.

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We are now in year 6 of the housing downturn and it is difficult to find too many signs of optimism amongst the investing masses. Housing busts have historically lasted about six to eight years, but there is a perception that it’s “different” this time around and massive shadow inventories can help keep the housing market suppressed for at least another half decade. A recent estimate from CoreLogic puts the shadow inventory at around 1.7 million homes. Some even suggest that this number has potential to rise more over the next few years.

Given this, a lot of people view the housing market as a lost cause right now. Until the excess inventories are worked out of the system, it is argued, the housing market cannot recover. This is where I find myself largely in disagreement.

We don’t have a supply problem. We have a demand problem.

The demand problem comes from two major sources:

(1) High unemployment / low job security, and

(2) Overpriced housing

The latter is important because attempts to prop up the market by keeping prices artificially high tend to exacerbate the problem, by not allowing prices to push down towards a new equilibrium. I’d also throw in the Federal government’s 20% down payment rule proposal as another hurdle to a healthy recovery, and it’s not totally clear what will happen on that front, yet. It’s something to keep an eye on, but at some level, prices will get low enough to compensate even for that.

Before I get into why things will improve more than people expect, let’s take a look at just how bad things are right now.

The ‘00s Housing Boom

The ‘00s housing boom was not completely unprecedented in terms of volume. When you look at the historical data, we had much bigger boom years than we did in the ‘00s. However, the ‘00s boom was significantly lengthier than previous booms, lasting nearly nine years, compared to prior booms that tended to last roughly three to six years.

The following table shows US housing starts and population from 1959 to the present. Note that the last column is “Housing Starts per Person”, which was my attempt to create a normalized measure for housing.

Over that 52-year period, the average number of housing starts was 1.48 million annually. The chart below shows housing starts each year (red line) versus that average figure (green line).

While the boom was somewhat typical, if lengthier than average, the housing bust is completely atypical and unprecedented over the past five decades. Before 2008, the previous low level of housing starts in our sample period was 1.01 million during the early ‘90s recession. Right now, we’re on course to have our third consecutive year with less than 60% of that total.

I created the “starts per person” stat to try to gauge a normalized level of housing production given our increasing population. However, the metric has some flaws. If you look back at the table, it would appear that “starts per person” is decreasing over time. Perhaps as American cities become more developed and the quality of the existing housing stock becomes higher, we simply do not need as much new housing per person as we did before.

With the following chart, I try to piece together what a “normalized” housing production level might look like in the 2010s.

My estimate from the above info is that a normalized level of production would imply around 1.4 to 1.6 million housing starts, or about a 150% increase from current levels. But even if we veer towards the extreme conservative estimate and assume we should have .004 housing starts per person; that would still put us at 1.25 million starts, a 110% increase from the current levels.

This puts my estimation very close to one generated by Macroeconomic Advisers, which is estimating that based on demographic trends, household formation rates, and housing stock depletion; the US would need to add, on average, 1.6 million new homes each year for the next decade.

While all of this is based on somewhat abstract population, housing, and demographic projections, it is somewhat telling that all these figures suggest that housing production will need to increase dramatically over current levels of production. Let’s shift away from this discussion, however, and look at pricing and supply/demand dynamics.

Prices and Scarcity

It may seem preposterous to suggest that we currently have a condition of housing scarcity in many places, but there’s an increasing amount of evidence supporting this view. One of the first signs of this is rising rental rates. While it is anecdotal, I had noticed that rental rates were increasing at a dramatic pace in urban Atlanta over the past year. Rents in my area had increased about 10% to 15% year-over-year on comparable units of nearly every apartment complex I had monitored; and the prices continue to go up now.

This suggests that the rental market isn’t very soft at all. With rapid rental price increases, coupled with falling housing prices, suddenly buying is looking a lot more attractive in Atlanta. A recent New York Times article affirms my anecdotal analysis. The Times article looks at price to rent ratios. Not unlike the P/E ratio for stocks, a ratio of 15 seems to be near the long-term average for Price/Rent.

Under this line of reasoning, housing in Atlanta, Los Angeles, Miami, Minneapolis, St. Louis, Las Vegas, Cleveland, Detroit, Phoenix, Pittsburg, and Tampa look relatively inexpensive compared to the alternative of renting. Whereas, housing still looks comparatively unattractive in San Diego, New York, Washington DC, Silicon Valley, and the Pacific Northwest. While this would suggest that buying a home is only attractive in part of the country, this is nonetheless, dramatically different than the environment a few years ago, where buying a home still looked extraordinarily expensive compared to renting in nearly every major US metropolitan area.

The Wall Street Journal offers another interesting metric: the price to income ratio. WSJ examines the historical norms for the price/income ratio in several major US markets. Once again, we get a divergence, with many cities now below their historical averages; but several are still above historical norms.

In the aggregate, WSJ finds the current Price/Income ratio to be 14% above the historical average for the entire US. The US historical average for P/I is at 2.9 and the current ratio is 3.3. Still, 14% is not outlandishly high, and WSJ’s data only goes back to 1985, meaning it contains two major housing busts, but only one housing boom.

In the aggregate, all this data would seem to suggest we should at least be prepared for another 10% to 15% drop on the national level, but some major markets might have bottomed or be very close to bottoming right now.

Of course, Price/Income has a few major flaws; particularly in markets with major development restrictions. In those sorts of markets, housing prices always stay artificially high due to scarcity. Therefore, you have to compare housing prices with rental prices to know the full story.

One thing that is clear is that rental vacancy rates appear to be declining rapidly in many markets. Using Census Bureau data, I pieced together the rental vacancy rates over the past four years for many major US metropolitan areas and examined the trends over the past two years.

You can see all the data below; the last column shows the decline in vacancies between the most recent quarter (Q2, 2011) and the quarter two years prior (Q2, 2009). Highlighted in yellow are all the cities where the vacancy rate declined by more than 25%. Notice there are an awful lot of them!

In the two columns prior, you can see the YOY decline over the past four quarters and the four quarters prior to that. Highlighted in blue are the cities where the declines were greater than 12%. As you can see, nearly every city in the sample has a decline in vacancy rate over the past two years, with many have major declines.

If you’re wondering what all the green is in the above chart, I used that color for any quarter where the rental vacancy rate was below 8% in a given city. The data here suggests that the rental market is booming, which seems to be supported by what we’ve witnessed with residential REITs over the past few years.

Another issue being overlooked is that there might be a certain dichotomy developing. The housing boom was more an exurban phenomenon than an urban one. Subdivisions filled with “McMansions” popping up 40 miles outside any major city is still one of the preserving images of excess. Yet, there may be a shortage in housing in urban and inner suburban markets, and we seem to be experiencing a shift in consumer preference, with more people favoring these submarkets. This could suggest that we may have another boom that is coming over the next decade; but that the nature of it could be significantly different from the last boom.

Employment and Housing

This all brings us to the issue of employment. Employment is one of the major factors holding back a fuller economic recovery. It’s also holding back housing. However, employment and construction are intricately related.

Construction workers, along with people in production and transportation related professions, tend to be less educated than their counterparts in management, office, and service occupations. Using the BLS data, we can see that those with lower levels of educational attainment have suffered the most during the housing bust. The unemployment rate for those without a high school diploma has gone from a low of 7.1% in 2006 to the current level of 15%.

Taking a closer look at occupational unemployment data, we find the same sort of trend.

Notice that construction unemployment hovered around 6% during the housing boom, but is now around 13.7%. Even this is a dramatic decrease from two years ago when the figure was 18.4%. However, we should add an asterisk to that thought, because part of that drop in construction related unemployment is the result of a lower labor force participation rate; suggesting the real unemployment for construction workers might actually be a bit higher than the current figures suggest.

Even many of the other occupations listed will experience lower unemployment levels with a boost in construction. After all, more construction activity will mean more accountants, more office workers, and more support staff. So the takeaway here is that unemployment remains stubbornly high precisely because the lack of a rebound in housing. If housing rebounds, we’ll probably finally start to see some progress on lowering the stubbornly high unemployment rate; which, in turns, means we’ll see more demand for housing. It’s a virtuous cycle of sorts and we could see things improve more rapidly at an unexpected future time.

What's Holding Things Back?

I've already mentioned two high-level issues holding housing back: unemployment and high prices. There are several other factors that I believe are also contributing to the poor environment right now.

(1) Consumer confidence

(2) Lending activity

(3) Underwater mortgages

(4) Regulatory environment

Consumer confidence is a simple one. Due to the falling prices over the past few years, we're seeing the opposite dynamic as we did during the boom, with people more fearful of buying. This seems like the most minor issue to me, because once things bottom and prices start moving upwards for a few years, this fear will likely disappear.

Lending activity has been a more important factor holding back housing. As the banks repaired their balance sheets, they were much less likely to make mortgage loans. However, there are some signs of stabilization in the banking sector. The rate of FDIC closures has certainly slowed in 2011. Moreover, banks hold significantly more capital now than they did in 2008 or 2009. Declining yields on US treasury bonds could also provide further incentive for the banks to start making more mortgage loans. Overall, this issue hasn't totally disappeared, but I believe we're starting to turn the corner on it.

Underwater mortgages remain a big issue in the housing market, as many homeowners are essentially stuck in their current house as a result of it. It's not uncommon for a homeowners to be employed and be able to service their mortgage; but if they are underwater, they have to take a huge hit if they sell the property. This has led to a situation where many people who would otherwise buy a new home have decided to stay put and not take the huge one-time hit. This situation, too, will improve with time.

That leaves the regulatory environment, which remains my biggest concern. During the housing boom, Congress and the Federal Reserve underreacted to what was going on. The Fed even had the audacity to lower interest rates in spite of major inflation in the housing market.

Now, we've moved to the opposite end of the spectrum, where government entities are overreacting. The 20% down payment is one example, but there are several more. Dodd-Frank has also put a lot of arbitrary requirement onto the banks, which has made them less profitable, and hence, less willing to lend out. Many bankers remain annoyed by Federal micromanagement of lending, as well. Main Street Bank of Texas even went so far as to surrender their banking charter, to get away from the FDIC's arbitrary enforcement actions against them. They decided to pursue a deal with a private equity firm and become a non-banking lender. From all the signs I see, the regulatory environment right now is the issue most likely to hold back the housing sector in the long-run.

In spite of these issues, I think the supply/demand dynamics will eventually trump all, and we will start to see a recovery. However, these issues could help determine how long it will take for housing to recover and how large the recovery will be.

Why I’m Buying the Homebuilders

At some point, the realities of urban population growth coupled with an increased consumer preference for rental housing are going to force rental prices upwards enough, so that a significant amount of new construction is needed to alleviate price pressures. There’s already evidence that we’re reaching that stage in some markets. Given the fact that very little construction has taken place over the past few years, relative to the prior decades, it stands to reason that we could see evidence of significant undersupply in the housing market.

While it’s difficult to predict when things will start to rebound and at what pace the rebound will take place, suffice it to say that the current level of housing production is not sustainable. My prediction is that we will see a gradual recovery of the housing market over the next few years and we’ll slowly move back towards 1.5 million starts per year; this seems to be much stronger than most people are expecting right now.

All of this makes the home builders look like a very attractive investment opportunity. Even if, after three years, we only see an improvement to 900,000 starts, many of the builders should see a large increase in profitability and cash flows that could drive up stock prices significantly.

Buying into the builders is not for the faint of heart. Given all the carnage we’ve seen already, it wouldn’t surprise me to see another 50% drop in prices sometime in the next 12 months. It could take several years for the builders to rebound, so this is a poor strategy for anyone who might need to pull their cash out of the market any time soon. But for those willing to ride it out over the long-term, I think this will prove to be one of the better investment classes over the next 5-8 years.

As far as builders go, I favor Pulte (PHM), Toll Brothers (TOL), and DR Horton (DHI). I may add some others or add to my current stakes in these three builders if I see attractive pricing and fundamentals.

Disclosure: I am long PHM, TOL, DHI. I own long-dated call options on a few homebuilders.

I think your evidence better supports a thesis that apartment housing will increase to support the increased need of rental space, since anyone who qualifies for a house under current lending policies already has one. It's a credit-worthiness problem, rather than a consumer confidence problem. I could definitely see the rental space having a big-time boom time in the near future. Single-family homes? Not so much.

You are unquestionably correct, but the question really is the time-frame. That's the whole enchilada. Your analysis is largely parallel to, but way more detailed than, an analysis I think I saw FloridaBuilder do here a year or so ago. (Or was it you? -- I don't know, but I remember the former Florida builder talking about about this during the most recent chimp context.) And anyway, that was a year ago, and the stocks are all down since then. (I think Pulte was one of his favorites, too. Hopefully he didn't have 1/2012 LEAPS, and I would worry about 1/2013 LEAPS, too.) I don't see a catalyst before then. Now, if I could get a specially-written call option with a 1/2016 expiration date on this industry, I would buy THAT in a heartbeat.

Also, I would want more data on the amount of homes that were and are second homes. Obviously that fed a lot of the foreclosure pipeline. But this is a non-played-out demographic story, too, with the babyboomers owning a large number of second homes, which they may downsize from somewhat (many others will pass the second condos and second homes down to the next generation). I'm usually a big fan of dismissing "this time it's different," but it's at least possible structural housing starts will be on a lower trajectory, at least until the baby-boom hump passes on; and keep in mind that this crisis happened precisely at the time when the first tranches of baby-boomers started retiring, so to the extent there is a demographic aspect involving second homes that likely has ten more years at least to play out. It may be the number of second homes makes it a total non-issue, but it would be nice to know the data.

"...there is a perception that it’s “different” this time around and massive shadow inventories can help keep the housing market suppressed..."

There's plenty of evidence that suggest that it is different. A record number of people can't even afford food, let alone a home. Nearly 9% of mortgages are still delinquent...~800% of the average in a healthy market. 20%+ of would be buyers are either out of work or don't have a solid work history required to get a loan. Mortgage rates are at all time lows, and people still aren't buying homes...what happens if mortgage rates return to a historically average 7-8%?...housing prices will collapse.

Despite all of this I won't argue that investing in these homebuilders is a mistake. Several large public builders (DR is one of them) have bought up tons of land from bankrupt builders in my area. They're now building out communities and selling new homes for far less than any of the local builders are still trying to get. The public builders are growing...not on rising prices (I don't think prices will reach previous highs for decades), but on rising market share.

Having just done some house hunting in the Milwaukee area this weekend it is easy to see why new isn't selling. $300,000 plus for a new house 2000 sqft, no basement, no landscaping, uninsulated unfinished garage, cheap painted woodwork, low quality cabinets and windows. $70,000 for a lot 30 miles from Milwaukee in the country. To get a nicer home with the better stuff closer it takes $600,000 or more.

It is easy to spot the problem existing homes. Many needing paint, bad shingles, landscsaping untended. Also looked at an older house that was being flipped, they must be kidding! Obviously just some interior cosmetics and a $260,000 price for a 55 year old house not in great condition. Who buys there things?

On the other hand (to comment #9) - I just picked up a house that I will be renting out. FMV rent for the area and house is $1,000/month. Cost of house ready to rent (no major repairs etc) $87K. Rental rates in the area are on the rise as people have lost houses and cannot qualify for another to buy - but still need to live somewhere.

It all depends on the area you are in. A lot of households are becoming renting households instead of owning households - a trend that I would expect to continue.

Hoyl sh*t this is a freaking fabulous post Jakila, thanks for sharing. +1!

I've been a fan of homebuilders the last 6-12 months as well and agree with many of your points.Eventually production has to increase. I'm actually somewhat excited about the recent overall market correction as I can scoop up more shares on the cheap of homebuilders.

I like your list but I would definitely add MDC into the mix as well.

As an aside, this is a great time to be patient when buying fellow Fools. Don't chase in this situation, only buy on corrections aka now. Homebuilders are going to continue experiencing a lot of pain before things get better, use that to your advantage and buy on dips. Happy buying everybody.

Not trying to be difficult here, but I'm not sure the "housing starts per person" is the best way to look at it. It's an apples-to-oranges comparision because it's the rate of change in one figure, compared to the absolute value of another figure.

I prefer to use the ratio of housing starts to the yearly change in population, which I think gives a great indication of whether or not we are building too many houses. That stat is here.

The inverse of that graph (population growth over housing starts) is even better because it gives an intuitive number. The average number of people per US household is around 2.4, and many people have predicted that it will continue to fall, and eventually end up around 1.6 - 1.8 (assuming that number is sustainable). So, whenever this ratio is below 2.4, we are decreasing the size of an average household in the U.S.

Now, going back to the first graph, we can see that it coincides almost perfectly with the US home ownership rate (as we would expect).

The home vacancy rate does not seem to correlate at all with the home ownership rate (inversely or otherwise). This tells me that a lot of the overbuilding was a result of houses that did not affect the home ownership rate. In other words, people were building second homes, investment properties, etc.

So, in terms of predicting a recovery, I would look primarily at housing starts, population growth, and the home ownership rate. And household debt. These are the things that hold back the recovery. Vacancy rates and shadow inventories are less important, in my opinion. The real, painful, "deleveraging" of the economy is best reflected in the home ownership rate & various debt statistics.

I'm actually a little more optimistic than most people. The home ownership rate has already dropped to 1999 levels. I guess the question is, how low does it need to go? Not back to 64%, I hope. For all I know, it may already be at a sustainable level.

Household debt service payments are back to where they were 15 years ago.

Non-mortgage debt has dropped to where it was 10 years ago. Consumer spending is picking up, while at the same time consumers are also paying down their debts. That seems very encouraging to me.

Total debt (including mortgages) is still very high, but I'm still encouraged because of the previous graph. Not all debt is the same, and paying 5% on a mortgage isn't the same as paying 25% on a credit card.

I'm not even that worried about any of this stuff anymore. I think the Euro debt crisis is the one thing that may plunge us back into a recession.

#10 I agree that rental rates may be rising due to people unable or unwilling to pay the current prices for homes. It does make me wonder if one of the future bubbles will be rentals. If house payments are out of reach for many now, what happens when interest rates move up?

Along with unemployment I think wage stagnation also needs to be considered. A lot of the high paying labor jobs (GM, CAT, etc) are gone. (This was masked for a while by the loose lending period.) I know that where I work our wage increases have not kept up with inflation for a number of years but housing costs (taxes, insurance, etc) continue to increase.

One thing I havent seen mentioned at all is the impact of the removal of the Mortgage Interest Deduction. It just seems like stimulus maxed out, interest rates at record lows, housing prices still not meeting equilibrium in many arears, and tax breaks and such the housing market has more downside risk before it has upside potential, which I dont really see as a bad thing. Its only bad for people who want to sell. If you arent selling then who cares?

"It just seems like stimulus maxed out, interest rates at record lows, housing prices still not meeting equilibrium in many arears, and tax breaks and such the housing market has more downside risk before it has upside potential, which I dont really see as a bad thing."

I agree. Homebuilders/realtors use historically low interest rates as a selling point...they're sure to go up. They note that rising interest rates lower affordability, but for some reason believe that higher rates won't effect their pricing power. Most buyers are putting little money down and are buying on payment with little consideration on the high cost of the home. We have a whole generation of potential buyers now that think 4-5% mortgages are the norm...they're not. Every 1% increase in mortgage rates decreases payment affordability by ~10%. In most markets (those without scarcity issues, etc...), rising interest rates will push home prices down significantly. Buyers are now considering the impact of the loss of the mortgage interest deduction, local budget problems and rising tax rates, etc... They're obviously already being very cautious...rising interest rates would just make them that much more cautious.

ETFs - You mention the declining size of the average household. I think there's better odds that we see the opposite. Recent college grads are having trouble finding decent work. A large percentage are moving back home. Young people aren't starting families and having children...they're waiting longer and having fewer children when they do get married. For many that got burned in the housing collapse...owning a home has lost it's appeal...possibly for good. A recent report showed that it's currently cheaper to buy than to rent in a majority of areas...that is not sustainable, and it won't come back in line by home prices increasing. It will be brought in line as rental units are built out to meet demand and rents collapse. If interest rates rise at the same time, payment affordability will decline and it will once again be far cheaper to rent than to buy.

A+ Well written and thought out, with plenty of stats, as usual for Jakila. Motley Fool should charge admission to read your posts, as they are better researched and more thought provoking than vast majority of articles on this website!

I am moving in your direction with this buy real estate idea, as I am worried about HYPERINFLATION. This is the added kicker or bonus of owning leveraged real estate later this year going into 2012 and 2013. I am waiting to sift through rumble of FLASH DEPRESSION in second half of 2011 for U.S. economy first before going major long in them.

UPDATE: I am doing better for performance at my Covestor portolio - been ranked #1 for the last 3 month performance trend during all of August (and likely September) out of 70 portfolios eligible for IRA investment mirroring. If market doesn't move up much, I should be on their master list of Top 10 or Top 5 out of 185 portfolios in total for trailing 3-month performance when that number comes out September 1.

Good luck all in your investing adventures, as we have a host of serious imbalances in the economy that will take another 6-12 months to work through.

From 2007 to 2010, the last 4 years of the decade, the US built less than 3.5mm homes. We have now potentially UNDER BUILT in the last half of the decade, by as much as we OVER BUILT in the first half. We have built almost exactly the same number of houses from 2000-2010 as we built from 1990-2000 -- around 14mm with population growth around 30mm in both periods (subject to official 2010 Census results).

Estimates of the US population in 2020 vary, but if the past is any indication, we will add between 25 and 30 million people over the next ten years. And as a result, we will have to build between 13-15mm houses by 2020. Housing starts will need to double or triple in short order to keep up with population growth – especially if they stay depressed in 2011

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We are currently on a pace to only build ~5M homes in this decade or 1/3 of what will ultimately be needed. No doubt foreclosures are holding new home construction back as builders don't want to compete with fire sale prices however a foreclosed home sale adds zero to the housing stock and can't possibly hold the new home construction market back mid to long term.

IMO housing will only truly recover when the job situation improves and the bankers start helping out the people they screwed. Not that I am siding with the sub prime crowd, it's just that their greed affected everyone.

The bankers need to realize that some of the toxic loans of the past are just not going to pay the interest. It is best to write down these loans or reduce payments in an orderly fashion and move forward.